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Changing Taxation of 401(k)s Could Discourage Savings, Sponsors

Many companies would drop 401(k) plans or consider dropping them, according to American Benefits Council survey.

As politicians search for a way to avoid the fiscal cliff, the tax benefits awarded to defined-contribution retirement plans such as 401(k)s look like a tempting source of new revenue. But a recent survey shows changes in the tax treatment of 401(k) plans could discourage employees from saving and lead some companies to discontinue plans.

According to an American Benefits Council survey of more than 500 companies, 91% of those surveyed say the fact that employees’ 401(k) contributions are excluded from current income tax is either very important or somewhat important in their decision to contribute to the plan, and 73% say employees contribute more to the plan than they would otherwise because of the tax situation.

The survey asked companies about three different options for altering the tax treatment of 401(k) contributions. One would subject both the employer and employee contributions to income tax but give workers an income tax credit equal to some portion of their annual contribution; the survey used 25%. Another approach, the “20-20” proposal, would limit the total of the employee and employer’s contributions to the employee’s account to the lesser of $20,000 a year or 20% of the employee’s compensation. A third option, the tax exclusion limit, would affect only workers in the top, 35% tax bracket; by capping their tax benefit at 28%, it would require those employees to pay 7% tax on their 401(k) contributions.

Seventy-one percent of respondents were opposed to the 25% tax credit option, with 37% of those strongly opposed. Seventy percent were opposed to the 20-20 proposal, with 30% strongly opposed, and 63% were opposed to the tax exclusion limit, including 30% strongly opposed.

When asked about the impact on employees, respondents again were hardest on the 25% tax credit. Seventy-two percent say the tax credit proposal would have a negative impact on employees’ retirement preparations, including 28% who expect a great deal of negative impact; 58% see a negative impact on employees’ saving from the 20-20 proposal, including 22% who see a strong impact; and 50% see a negative impact from the tax exclusion limit, including 13% who cite a strong negative impact.

Many companies say they would eliminate their 401(k) plan or consider eliminating it if the tax treatment changed. Eight percent of companies say they would drop the plan in response to a 25% tax credit, while 38% would consider dropping the plan; 9% would drop the plan and 26% would consider dropping it in response to the other two proposals.

James Klein, president of the American Benefits Council, who's pictured above, says that since companies’ reactions to the three options “was pretty consistent and pretty negative, we think virtually any proposal that is going to curtail the tax treatment for workers is going to generate that kind of negative response from employers and workers themselves.”

And he notes that the concerns about tax changes were higher among larger companies.

Robyn Credico, defined-contribution practice leader for North America at Towers Watson, links the greater response from larger companies with their growing realization that older workers who can’t afford to retire pose a problem. “Larger companies are struggling now with getting people to save enough so they can actually leave the workforce in a meaningful way.”

For years, companies ignored the issue, she says. But in the last three or four years, as more older workers have delayed retirement, companies have started to pay attention.

“It’s a pretty large employer cost,” Credico says, noting that older workers tend to have higher salaries and cost more in terms of health coverage. “If employers don’t have a means to get people to save, there is actually a huge financial burden to them.”

“Economic times in conjunction with what we’ve done to [defined-benefit pension] plans have made it an important issue,” she adds.

Changing the tax treatment of 401(k)s could push more workers toward Roth 401(k)s, in which workers contribute after-tax dollars and then aren’t taxed when they withdraw money in retirement. Credico says that 45% of 401(k) plan sponsors now offer a Roth option, “but less than 5% of the people actually use it, and that 5% is the same for high-paid employees as low-paid.” She argues, though, that the outlook for future taxes involves a lot of uncertainty and is hard for people to factor into their retirement planning.

About half of plan sponsors said they were likely to make changes to non-qualified plans if the tax treatment of 401(k) plans changes, with 24% saying they would start a new non-qualified plan, 17% saying they would expand eligibility for their current plan, and 9% saying they would increase contributions to their current plan.

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